Land Markets and Prices
Even in a relatively small region, the number and heterogeneity of parcels and the number of different uses to which each parcel could be put mean that the number of different ways of distributing these uses among the parcels will be extraordinarily high. How should we (i.e., society) seek to find the one land use pattern that maximizes land rents? In the United States, as in most other countries, we rely on a private land market to do most of the work of determining what uses of land are located on which parcels of land. The private land market works the way all markets do: Buyers and sellers agree on the terms by which land, or sometimes just the services of land, will be transferred between them. The most important aspect of the transaction is the price, because it is the price that reflects all the thousands of factors that go into determining the usefulness and desirability of using a particular piece of land for a particular purpose.
Consider a parcel of land devoted in perpetuity (or at least for a very long time) to a particular use, say, a house, or a small office building, or a public park. The use in question generates a stream of annual net benefits, or annual land rents. The present value of this stream of annual rents can be written explicitly as
Where R stands for annual rent and r is the R’s in the numerator are all the same, this sum equals R0+R/r. Each different use of the land generates a different PVr. In a completely free, competitive land market, the market price of a parcel of land equals the highest of all the different possible PVr’s associated with the different ways that the land could be used.
The reason for this is that in the bids and offers of buyers and sellers in the land market, all the potential net benefits associated with owning a piece of land will be capitalized into its price. Suppose, for example, a piece of land is currently used for farming, and in this use it has a value of $5,000 per acre (i.e., the present value of rents when the land is used for agriculture is $5,000). Now suppose that, because of the growth of a nearby town, the land could potentially produce a stream of rents (as house lots) with a present value of $12,000. If there is a competitive land market, the market price for this (and similarly situated) land will increase to $12,000, even though it is still used for farming. This is because the price will be bid upward to reflect the potential rents the land could produce, not what they happen to be producing in the short run.
Thus, all changes in the net benefits producible by a parcel of land, as long as these accrue to the owner of that land, will get capitalized into its price. For example, suppose in an urban area steps are taken by pollution control authorities to reduce the level of air pollution. There is no direct market for clean air; people do not literally buy and sell quantities of clean air. But if cleaning up the air in the community adds $85 per year to the net benefits of living in a house there, the prices of land on which to build house, or of land on which houses already exist, will increase to reflect the capitalized value of these new net benefits. The land prices, in other words, will increase by an amount equal to
85 85 85 85
85+ ___ + ___ + ___ + … = 85+ _____
1+r (1+r)^2 (1+r)^3 r
There are several provisos to the idea that land prices reflect land rents. One has to do with land taxes. Virtually every community in the country raises a portion of its revenues though land taxes; in many cases this is by far the largest source of funds. The part of land rents that is paid in taxes is not capitalized into its price since these rents do not end up in the pockets of the buyers and sellers in the private land market. Thus, communities have sometimes attempted to use differential tax rates to affect land rents and the uses to which land is put within their borders.
Another proviso is that land prices do not necessarily reflect all the net benefits associated with the use of the land. Land prices adjust to reflect (i.e., “capitalize”) all net benefits that accrue to the user of the land. But if some net benefits accrue to other, they are not so capitalized. The best example of this is certain environmental impacts that particular land users may have. Suppose, for example, that a certain large parcel of land is expected to be used for building a number of single-family dwellings. The price of land in this parcel will reflect all the benefits and costs that will accrue to those who end up living in the houses: amenity values (perhaps the land is close to a public park), value of time in commuting (perhaps it is near a rail commuting line), value of time to the nearest grocery store, and so on. But suppose the land is also a strategic piece of watershed and building houses on it will impact negatively (i.e., inflict costs) on others who live downstream from the new development. These are external costs. Were they to be capitalized into the prices of the land in question, these prices would be lower (because net benefits are lowered). But because they are external costs, they will not be so capitalized. In cases like this, normal market prices of land will not accurately reflect all the social benefits and costs arising from the uses creating the externalities. By the same token, the prices of land in the proposed development may be external costs and/or benefits flowing in from elsewhere. If a factory is built next to this land, for example, land prices will be pushed down because of the external costs stemming from this source